Bank Regulation

WHY REGULATE BANKS? Banks are intermediaries between money suppliers and those who need money. Commercial banks are most heavily regulated financial institutions. Five main reasons for regulation: I. The first is to ensure the safety and soundness of banks. The purpose is to maintain I) domestic and II) international confidence, III) protect depositors and ultimately taxpayers and IV) maintain financial stability. With safety and soundness, a financial system provides for the efficient allocation of the nations’ resources because the payments system is reliable and banks extend credits that stimulate economic growth.

Most bank debt is held by small creditors. In the view of many bankers and central bankers, regulation is motivated, in particular, by the need to protect these small depositors who are unsophisticated and unable to understand the balance sheet and off – balance sheet activities of the banks. The banking regulator represents the depositors. The central bank monitors the banks’ activities ex ante seeing to it that the bank meets capital adequacy requirements to ensure that there is enough capital to protect the depositors and making sure that the bank is doing the right thing in terms of risk management and ex post – in case of a crisis intervening by closing or restructuring the bank.

This goal is generally accomplished by limiting risk taking at individual institutions and by the government’ willingness to act as a lender of last resort. II. The second objective of bank regulation is that Central Banks use the regulation to provide monetary stability. This is evidenced by efforts to control the growth in the nation’s money supply and maintain the efficient operation of the payments system. Control over money supply may be implemented through reserve requirements. At present banks in Azerbaijan pay 10% reserve requirement.

III. The third objective is to provide an efficient and competitive financial system. Regulation has attempted to prevent undue concentration of banking resources that would be anticompetitive. This goal has generally been accomplished by restricting mergers and acquisitions that reduce the number and market power of competing institutions. IV. The fourth objective is to protect consumers from abuses by credit granting institutions. Borrowers should have equal opportunities to receive loans. Banks can’t discriminate on the basis of race, gender, age, geographic location, etc.

Banks must disclose why a borrower is denied loan. V. The fifth, final objective is to maintain the integrity of the nation’s payments system. Regulators ensure that banks clear checks and settle non – cash payments in fair and predictable ways, participants will have confidence that payments can be used to effect transactions. We must recognize that regulation cannot achieve certain things. 1. Regulation does not prevent bank failures. 2. It cannot eliminate risk in the economic environment or in a bank’s normal operations. 3. It does not guarantee that bankers will make sound management decisions or act ethically.

SELF – REGULATION There are suggestions that banks should regulate themselves. The role of Central banks will be simply to ensure that the banks file their returns on time, do not break basic capital rules. How can this work? The Chairman of Federal Reserve System in the USA Alan Greenspan believes that at least two forces will keep banks honest in their self –regulation. One force is transparency. The more information banks have to disclose about themselves, the least they can mislead others. The second force is that modern financial markets severely punish mistakes.

As soon as investors understood how weak the economies of Indonesia, Thailand, Malaysia and South Korea were, they fled in the link of an eye causing unprecedented financial crisis in those countries. Russia was similarly punished when its economy had problems. Bankers Trust, Lehman Brothers, UBS, Merrill Lynch and others were all humiliated by the markets for their mistakes. Throughout 1990s banks were too focused on making money by taking too much risk to think about consequences. Now, when they understood their mistakes they will be less risky in making investments. Theoretically it may work, but one day some bank is going to get into trouble.

It has to happen. So according to the suggestion of Alan Greenspan would Central Bank simply leave failed bank to the mercy of the market – which is not going to be soft to the bank – or step in and bail –out? Greenspan does not answer this question. But what he did is that when Long-Term Capital Management hedge fund had problems Federal Reserve bailed it out. Hedge Fund is essentially fund where there are a limited number of investors and the fund managers can take any positions buying or selling financial and non-financial assets. These funds speculate on price moves. They also have capital and debt.

This hedge fund was managed by well–known bankers and with two Nobel Prize winners. The bail -out caused genuine fury in some parts of Wall Street. Some analysts thought that Greenspan used people or taxpayers money to rescue the hedge fund. They thought he gave wrong signals to other banks demonstrating that those have a trouble will be saved by the Central Bank. Actually no public money was used. The banks which lent to this Hedge Fund pooled funds and helped Central Bank to bail it out. So that was in consistency with the view of Alan Greenspan. From the other point this fund was so large that if the fund failed in 1998 global financial crisis would be colossal.

Actually the Greenspan’s doctrine in action. The regulator oversaw the process while the banks themselves executed bail-out. The question of moral hazard is still open. Can any bank that does stupid things in the market expect to be bailed out? First, there will always be cases of institutions which are simply too big to be allowed to fail. Second, the bank must know who it is, large or small, and act accordingly. PRUDENTIAL CONTROLS I) Protective Regulation Aim is to limit damage to Depositors and stabilize banking system. Tools: a) Deposit Insurance Scheme; b) Lender of Last Resort a) Deposit Insurance Scheme A deposit insurance system guarantees that small depositors will receive their funds if their banks fail.

There are two objectives of deposit insurance scheme: i) help to stabilize financial system and ii) to protect small depositors. Regulators do not want see small depositors scared, line up outside banks. There are two important elements that should be kept in mind if the country wants to set up a deposit insurance scheme: i) First of all improve the banking system. Then the deposit insurance scheme must be compulsory and transparent. ii) Deposit insurance scheme must be also written into law.

The public should know what amount is covered and what is not. Deposit Insurance Agency should have a logo and should do advertising. The deposit insurance scheme changes from country to country. In the USA there is a bank insurance fund named Federal Deposit Insurance Corp. Currently deposits are insured in the amount up to $100,000. The insurance premium depends on capital of the bank. Maximum premium is 0. 27% of $100 or 2. 7% of $100,000. The fund collects premiums from banks, totals about $40 billion (2000). Canada has very small fund and it borrows funds if necessary. In the UK, there is a fund.

The depositor can receive 100% of ?2,000 and 90% of amount above but up to ? 31,700. But mainly if some bank fails, the authorities tell to the surviving banks: “OK, surviving banks, let’s collect some money to pay the depositors. ” Deposit insurance agency may be privately owned (if there is concentration of power) or publicly. b) Lender of last resort When the bank needs liquid funds in large amount – when there is significant run on deposits – and the institution can’t raise funds in the market quickly enough to offset its losses, it may, as a last resort, turn to the central bank for an emergency loan.

Problems with deposit insurance scheme and lender of last resort Deposit insurance acts similarly to bank capital and is a substitute for some functions of bank capital. If there would be insurance of deposits, depositors look to the company’s capital as a safety net in the event of failure. Low capital means that the company must pay a risk premium (higher interest rate) to attract funds or they will find it very difficult of not possible to borrow funds. Insured depositors do not look to the bank’s capital position in the event of default. Depositors will look at insurance fund.

To avoid moral hazard associated with lender of last resort operations, some central banks maintain a policy of “constructive ambiguity” as to what they will do, how they will do it, and when they will do it. That is the access to emergency liquidity support facilities is made uncertain. The objective of liquidity support is to prevent illiquidity at an individual bank from leading it to insolvency, and to avoid deposit runs from one bank to another. Also many large banks are considered as “Too Big To-Fail” (TBTF). A creditor of large bank would receive informal insurance of any amount they would hold in large bank as the Central Bank steps in to save big banks.

Deposit insurance has historically ignored the riskiness of a bank’s operations, which represents the critical factor which leads to failure. Thus, two banks with equal amounts of domestic deposits paid the same insurance premium, even though one invested heavily in risky loans and had no uninsured deposits while the other owned only US government securities and just 50% of its deposits were insured. This created a moral hazard problem whereby bank managers have an incentive to increase risk. Managers could use deposit insurance to access funds via brokered CDs in $100,000.

Buyers were not concerned about the quality of the underlying bank because their funds were fully insured, that is why they did not impose market discipline in the form of higher rates to be paid for additional risk. II) Preventive Regulation Ratios AZM bn Weight Risk weighted ASSETS 31/12/03 assets Cash and balances at NBA 12 0% 0 Correspondent accounts 10 20% 2 Treasury bills 13 0% 0 Gross loans* 54 100% 54 Premises and goodwill 8 100% 8 Other assets 3 100% 3 TOTAL ASSETS 100 67 LIABILITIES Demand deposits 50 Time deposits 15 Borrowed funds 15 All other liabilities 10 TOTAL LIABILITIES 90 Share capital 3 Retained Earnings 7.

TOTAL CAPITAL 10 TOTAL CAPITAL & LIABILITIES 100 * I) Lending to related parties AZM 5 bn. II) Lending to insiders AZM 3 bn. 1 Minimum share capital $2. 5 m 2 Capital adequacy ratio 12% = 10 / 67 15% 3 Liquidity ratio 30% = (12+10+13)/30 70% 4 Lending to related parties 25% = 5 / 10 50% 5 Lending to insiders 10% = 3 / 10 30% 6 Participation in share capital of other companies 10% = 0 / 10 0% 7 Investment in premises Not more than capital On – site inspection CAMEL analysis Capital Assets Management Earnings Liquidity Reading material 1. Rose, Commercial Bank Management 2. Work-paper, Why to regulate banks? 3. Koch, Bank Management.